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Capital Flows Speed Catch-Up in Europe

Skepticism has increased about impact of capital flows on emerging economies

In Europe, capital flows have played largely positive role

Pattern in Europe may be bellwether for new role for international capital

Following recent crises in emerging markets, especially Asia in 1997-98, Russia in 1998, Turkey in 2000, and Argentina in 2001, economists and policymakers alike have become more aware of the potential dangers from international capital flows.

And skepticism regarding the benefits of such flows has recently increased as research, including by IMF economists, has found little evidence that capital inflows can lift long-term economic growth in developing countries.

But in a new working paper entitled "International Finance and Income Convergence: Europe is Different," IMF economists Abdul Abiad, Daniel Leigh, and Ashoka Mody show that in eastern and central Europe, capital flows facilitated by financial integration have helped support a more rapid income convergence between the new European Union members and their richer neighbors in western Europe.

Standard economic theory predicts that capital should flow from richer to poorer countries. But capital has in recent years been flowing from some fast-growing poor countries to some rich countries rather than the other way around, most notably demonstrated by China's large current account surplus and the United States' large current account deficit.

Some economists believe that this reversal reflects a new state of affairs: fast growing developing countries run surpluses because they generate more savings than they can use, in part because their financial systems may be underdeveloped. Which is fine, the argument goes, since there seems to be no growth dividend associated with capital inflows.

Differing growth processes

In their paper, Abiad, Leigh, and Mody argue that "it is important to recognize that growth processes around the world differ in substantive ways." The authors find that in a global sample of economies, capital does flow downhill from rich to poor countries, but that this downhill flow is most evident in Europe, owing to its much higher level of financial integration.

What is more, these European capital inflows have supported an impressive process of income convergence. When it comes to the role of international capital flows in economic development, "Europe is different," they conclude.

The question, which the authors leave unanswered for now, is whether the patterns seen in Europe—which is much more financially integrated than other regions—may be the bellwether of a new and more positive role for international capital in helping increasingly integrated developing countries catch up with rich countries. In the words of the authors, "as global financial integration proceeds apace, it may draw a wider circle of countries within its fold, changing the direction and effects of international capital flows."

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